Chapter 4 Principles of Corporate Finance Eighth Edition Value of Bond and Common Stocks Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 4- 2 McGraw-Hill/Irwin Topics Covered  Using PV Formulas to Value Bonds  How Common Stocks are Traded  How Common Stocks are Valued  Estimating the Cost of Equity Capital  Stock Prices and EPS

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 4- 3 McGraw-Hill/Irwin Valuing a Bond Example If today is January 2004, what is the value of the following bond? A German Government bond (Bund) pays a percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO. Cash Flows

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 4- 4 McGraw-Hill/Irwin Valuing a Bond Example continued  If today is January 2004, what is the value of the following bond?  A German Government bond (Bund) pays a percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO.  The price at a 3.8% YTM is as follows

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 4- 5 McGraw-Hill/Irwin Bond Prices and Yields Yield Price

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 4- 6 McGraw-Hill/Irwin Valuing a Bond Example continued  If today is January 2004, what is the value of the following bond?  A German Government bond (Bund) pays a percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO.  The price at a 2.0% YTM is as follows

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 4- 7 McGraw-Hill/Irwin Stocks & Stock Market Common Stock - Ownership shares in a publicly held corporation. Secondary Market - market in which already issued securities are traded by investors. Dividend - Periodic cash distribution from the firm to the shareholders. P/E Ratio - Price per share divided by earnings per share.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 4- 8 McGraw-Hill/Irwin Stocks & Stock Market Book Value - Net worth of the firm according to the balance sheet. Liquidation Value - Net proceeds that would be realized by selling the firm’s assets and paying off its creditors. Market Value Balance Sheet - Financial statement that uses market value of assets and liabilities.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 4- 9 McGraw-Hill/Irwin Valuing Common Stocks Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the market capitalization rate.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks Example: If Fledgling Electronics is selling for $100 per share today and is expected to sell for $110 one year from now, what is the expected return if the dividend one year from now is forecasted to be $5.00?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks The formula can be broken into two parts. Dividend Yield + Capital Appreciation

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks Capitalization Rate can be estimated using the perpetuity formula, given minor algebraic manipulation.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks Return Measurements

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks Dividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends. H - Time horizon for your investment.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $ What is the price of the stock given a 12% expected return?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $ What is the price of the stock given a 12% expected return?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY. Assumes all earnings are paid to shareholders.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model).

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks Example- continued If the same stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends? Answer The market is assuming the dividend will grow at 9% per year, indefinitely.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks  If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher. Payout Ratio - Fraction of earnings paid out as dividends Plowback Ratio - Fraction of earnings retained by the firm.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks Growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations. g = return on equity X plowback ratio

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks Example Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks Example Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision? No GrowthWith Growth

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks Example - continued If the company did not plowback some earnings, the stock price would remain at $ With the plowback, the price rose to $ The difference between these two numbers) is called the Present Value of Growth Opportunities (PVGO).

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Valuing Common Stocks Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments. Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity.